Market update: Volatility rises after strong rally in equity markets

by Badgley Phelps | Jun 05, 2019

The stock market had an unusually strong start this year with the S&P 500 Index up more than 18 percent through the end of April. In fact, both the S&P 500 and the NASDAQ Composite Indexes reached record highs about a month ago. However, the market has been soft in recent weeks. What’s driving the recent volatility and where do we go from here?

The current environment

For most of this year, we have been in what could be described as a “Goldilocks” economic environment. By most measures the economy is humming along at a healthy pace with U.S. GDP growth of 3.1 percent last quarter and benign inflation. Recent inflation measures show that prices are only rising about 2.0 percent, a level that is not concerningly high or low. In addition, employment remains at multi-year highs and wage growth is solid. Perhaps most important, a major source of concern has been removed as the Federal Reserve has moderated their stance and is not expected to raise interest rates in the foreseeable future.

Market fundamentals have also been solid. Corporate earnings have been better than expected with profit growth of about 2 percent last quarter. While that is a modest increase, it is better than the consensus view that prevailed at the beginning of the year. Many market observers worried that we would experience a decline in profits after last year’s increase of more than 20 percent. Given the relative strength of earnings, the stock market reached new highs this year, yet the market’s valuation remains reasonable. At less than 16x the expected earnings for the next twelve months, the price-to-earnings ratio of the S&P 500 Index is trading slightly below its long-term average. 

What’s driving the recent volatility?

After setting a record high in late April, equity prices softened in May as investors grappled with the risks facing the markets. The most obvious market-moving headlines have focused on trade tensions and tariffs. Early in May, investors watched as trade talks became strained between the U.S. and China. Last week, plans to impose tariffs on imports from Mexico were announced. Clearly, there is concern regarding the potential for negative outcomes to these disputes, resulting in slowing economic growth and the possibility of disappointing earnings in coming quarters.

Perhaps even more important, there are signs that technology companies may become proxies for the U.S. and China to implement their agendas for national security and technology leadership. This is an important distinction as there is tremendous common ground where both countries benefit economically from a trade agreement. However, a sweeping resolution that requires either country to compromise on items central to their national agendas is much less likely. In short, an agreement focused on trade and economics is much more likely than one that incorporates structural reforms.

Another risk relates to the global economy as it appears to be softening. Recent statistics indicate a slowdown in major economies, particularly the Eurozone, with Germany being unusually weak. However, slowing growth is also evident in the U.S. The Federal Reserve Bank of Atlanta’s GDPNow forecast is projecting growth of just 1.3 percent for the second quarter as several recent economic indicators have suggested our expansion has become less robust. To be clear, in the near-term we do not appear to be at risk for a recession, but the deceleration in growth is something we are monitoring closely. 

The path forward

Market volatility has increased in recent weeks. However, it is important to put that in context of the strong start to the year with the market generating returns of nearly 20 percent in just four months. After such a strong increase, it is normal for the market to spend some time consolidating the recent gains. Looking forward we will be watching economic indicators closely, particularly those that may portend a change in the Federal Reserve’s policy, as well as developments on the negotiations with China and Mexico. At this juncture, we think it’s best to focus on the long-term and stay the course, but we will certainly keep you apprised if our views change.


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